Economic Growth vs. Social Insurance—Why Can’t We Have Both?

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Why do Republicans on the campaign trail tend to emphasize policies that are focused on enhancing long-run economic growth while Democrats tend to focus more on immediate problems such as high unemployment?

Republicans have a Club for Growth that grades politicians on their support of “free-market, limited government” policies that they believe are the key to economic growth. Democrats are more likely to pay attention to institutions such as the Economic Policy Institute where “policies that protect and improve the economic conditions of low- and middle-income workers” are promoted.

In general, Democrats seem much more focused on short-run economic problems than Republicans do. Is there any basis within economics for this difference in emphasis on which type of policy is most important?

As I’ll explain shortly, there is, or more precisely, there was.

The economics behind disagreements about policy

Some Republicans use the promise of economic growth as a ruse for their real goal, lower taxes on the wealthy. For them, it’s really a “Club to Lower Taxes and Cut Social Programs.” But today I want to focus on the economics rather than the politics.

What is the source of the idea that we cannot address both long-run growth and problems such as high unemployment and rising inequality at the same time? Why have economists and politicians chosen sides on which of the two is most important? There are two reasons for this.

The first has to do with a difference within the economics profession on what causes economic boom and bust cycles. One group of economists closely aligned with Republicans believes the source of business cycles is mainly supply shocks. In particular, adherents of “real business cycle” models believe that technological shocks are the main culprit in both booms and busts. Furthermore, monetary and fiscal policy cannot, and should not be used to offset the resulting economic fluctuations.

At any point in time, even in recessions driven by negative technological shocks (which include things such as poor rainfall, oil price shocks, and/or a decline in innovation), households and businesses are doing the best they can possibly do under the circumstances. There is no way for monetary and fiscal policy to make people better off. All policy can do – if it can do anything at all, these theories imply that policy has a very limited ability to affect the economy – is make things worse. The bottom line is that in these models short-run stabilization policy is counterproductive and growth is all that matters.

Another group of economists believe that demand side rather than supply side shocks are the main cause of variations in economic conditions over time. Negative demand-side shocks lead to an inefficient, suboptimal situation where the total amount produced is greater than the total amount purchased. Inventories begin piling up at businesses due to deficient demand at current prices, and this leads to production cuts, employment cuts, and disinflationary pressure.

Importantly, in the “New Keynesian” theory explaining how this occurs, monetary and fiscal policy can be used to effectively offset economic fluctuations and stabilize employment (monetary policy is preferred most of the time, but in severe recessions, fiscal policy also has an important role to play). This point of view aligns closely with Democratic economic policy objectives.

Most economists believe that both types of policies can help the economy. If that is the case, why not advocate both supply-side policies to promote growth and stabilization policies to offset shocks to demand (a point of view I endorse). This is where the second reason for the split between supply-side and demand-side policies comes in.

For a long time, economists believed there was a tradeoff between pursuing policies to stabilize the economy or bring about a more equitable distribution of income and long run economic growth. Addressing equity issues such as inequality would bring up an “equity-efficiency” tradeoff. If such a tradeoff exists, then the pursuit of a more equitable distribution of income would harm economic growth. When this was coupled with the view that the benefits of increased growth to those in the lower parts of the income distribution are much, much higher than the benefits of redistributing income, the result was that many economists abandoned calls for a more equitable distribution of income in favor of promoting growth.

A similar tradeoff was thought to exist for policies used to combat recessions. The taxes needed to support these policies, particularly those that fall on the wealthy, were believed to cause less entrepreneurial activity and lower growth. On the spending side, in addition to crowding out more efficient private sector activity, government expenditures on social programs were believed to dull the incentive to work, create a poverty trap, and harm economic growth. Thus, if the benefits of higher growth exceed the benefits of stabilization policy, as economists such as Robert Lucas argued they did, then we should focus on economic growth.

What does the evidence say?

Recent evidence has not favored the claims that supply shocks are the major cause of fluctuations, that policymakers face a difficult policy tradeoff between growth, stabilization, and equity, and that monetary and fiscal policy have little ability or need to intervene in an attempt to stabilize booms and busts.

First, on the source of fluctuations, does anyone seriously believe that events such as the Great Depression and Great Recession can be explained by productivity shocks? I don’t, and there is plenty of evidence to support the idea that demand side fluctuations are the predominant source of output and employment variability.

Second, on the benefits of long-run supply-side growth policy, there is little evidence to suggest that tax cuts do, in fact, raise economic growth. And even if they do, will tax cuts “lift all boats” as advocates of these policies claim, or will most of the gains go to the yacht owners? The evidence in recent years is clear. If tax cuts for the wealthy do spur growth, and that is doubtful, most of the gains flow to the top (not to mention the increase in inequality from the tax cuts themselves).

Third, on the costs of pursuing a more equitable distribution of income and providing social programs that help the unfortunate, recent evidence suggests that lowering inequality can actually raise economic growth. There was considerable resistance to this idea at first, but it is finding acceptance. If this research is correct, there is no equity-efficiency tradeoff to worry about, and reducing inequality may actually promote economic growth.

As for social insurance, while you can always find people who abuse any government program, including those that benefit the wealthy, the idea that social programs promote a culture of laziness and anti-work attitudes is hard to support with solid evidence. There may be costs to these programs, but they are small and nowhere near as large as supply-side advocates claim. In any case, the costs are dwarfed by the large benefits that accrue to those who truly need help.

Finally, on the effectiveness of short-run stabilization, the ability of monetary and fiscal policy to offset economic fluctuations appears to be much greater than many people realized prior to the Great Recession. For most economists, monetary policy has always been an effective tool for offsetting mild fluctuations, but it was thought to lose effectiveness in severe recessions. In addition, many economists had little faith in fiscal policy as a replacement for monetary policy in deep downturns.

But the Fed surprised us with its creativeness during the Great Recession, and while it was far from a cure-all, monetary policy had more impact than many would have predicted. In addition, the evidence from the Great Recession indicates that fiscal policy is a much more effective tool in deep recessions than many economists understood. There is still resistance to this evidence, but a fair examination of recent research leads to the conclusion that the benefits of stabilization policy are large and worth pursuing.

We don’t have to choose between growth and stabilization

Don’t get me wrong. Growth is very important and we should do all we can to promote it. Tax policy can matter in this regard, though concern over taxing the wealthy is misplaced, and we should structure taxes to minimize distortions while still paying attention to equity. But growth is not all that matters. How the gains from growth are distributed is a crucial factor, and there are large benefits from addressing short-run problems using monetary and fiscal policy, benefits that do interfere with our long-run growth objectives.

The evidence on these issues has changed dramatically in recent years, and those who cling to old-fashioned supply-side ideas as true believers, or as a ruse to promote tax cuts and cut social programs, are standing in the way. There are certainly benefits from policies to promote economic growth. But there are also large benefits from doing more to overcome costly fluctuations in output and employment, and we should not let discredited arguments about tradeoffs and the ineffectiveness of policy stop us from helping people who are hurt when the economy takes a turn toward harder times.

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.